ACKNOWLEDGEMENT

For successful completion of any task co-operation and co-ordination are very important so

was there. I would like to express my special thanks of gratitude to all my faculty members

who gave me the golden opportunity to do this wonderful project on the in “Types of Bond in

India”, which also helped me in doing a lot of Research and I came to know about so many

new things

I would like to specially thank Prof. Jay Desai (HOD) granting me to undergo the training at

Kotak Mutual Fund Ltd. and giving the opportunity to learn about various new things.

During my 45 days association with Kotak Mutual Fund, I have always been able to learn new

things and obtained enormous amount of exposure of investment. Therefore I am personally

thankful to Mr. Mann Sir and Mr. Karan Sir who continuously guided and directed me

towards successful completion of my work.

I also gratefully acknowledge the contribution from Mr. Nisarg Joshi , my project guide for

his continuous cooperation and suggestions for successful completion of the project and all

my Faculty Members who have always offered their warmest support for completion of this

project at Ahmedabad Institute of Technology,

During this project we learn how to conduct study, how to think logically, how to work and behave in a professional environment, and practical implication of the knowledge in the real world which we have been taught at institutions.

PREFACE

The Bond Market in India with the liberalization has been transformed completely. The opening up of the financial market at present has influenced several foreign investors holding upto 30% of the financial in form of fixed income to invest in the bond market in India.

The bond market in India has diversified to a large extent and that is a huge contributor to the stable growth of the economy. The bond market has immense potential in raising funds to support the infrastructural development undertaken by the government and expansion plans of the companies.

Sometimes the unavailability of funds become one of the major problems for the large organization. The bond market in India plays an important role in fund raising for developmental ventures. Bonds are issued and sold to the public for funds.

Bonds are interest bearing debt certificates. Bonds under the bond market in India may be issued by the large private organizations and government company. The bond market in India has huge opportunities for the market is still quite shallow. The equity market is more popular than the bond market in India. At present the bond market has emerged into an important financial sector.

EXECUTIVE SUMMARY

Bonds have many characteristics such as the way they pay their interest, the market they are issued in, the currency they are payable in, protective features and their legal status.

Bond issuers may be governments, corporations, special purpose trusts or even non-profit organizations.

Usually it is the type of issuer or the particular nature of a bond that sets it apart in its own category. We briefly discuss some of the main types of bonds below:

1. CORPORATE BONDS

2. GOVERNMENT BONDS

3. ASSET-BACKED SECURITIES

4. EUROBONDS

5. EXTENDIBLE/RETRACTABLE BONDS

6. FOREIGN CURRENCY BONDS

7. CONVERTIBLE BONDS

8. HIGH YIELD OR "JUNK" BONDS

9. INFLATION-LINKED BONDS

10. U.S. TREASURY INFLATION PROTECTED SECURITIES (TIPS)

11. MORTGAGE-BACKED SECURITIES

12. ZERO COUPON OR "STRIP" BONDS

The Major Reforms In The Bond Market In India

The system of auction introduced to sell the government securities.

The introduction of delivery versus payment (DvP) system by the Reserve Bank of India to nullify the risk of settlement in securities and assure the smooth functioning of the securities delivery and payment.

The computerization of the SGL.

The launch of innovative products such as capital indexed bonds and zero coupon bonds to attract more and more investors from the wider spectrum of the populace.

Sophistication of the markets for bonds such as inflation indexed bonds.

The development of the more and more primary dealers as creators of the Government of India bonds market.

The establishment of the a powerful regulatory system called the trade for trade system by the Reserve Bank of India which stated that all deals are to be settled with bonds and funds.

A new segment called the Wholesale Debt Market (WDM) was established at the NSE to report the trading volume of the Government of India bonds market.

Issue of ad hoc treasury bills by the Government of India as a funding instrument was abolished with the introduction of the Ways And Means agreement.

1. CORPORATE BONDS

A corporate bond is a bond issue by a corporation. It is a bond that a corporation issues to raise money effectively in order to expand its business. The term is usually applied to longer-term debt instruments, generally with a maturity date falling at least a year after their issue date. (The term "commercial paper" is sometimes used for instruments with a shorter maturity.)

Sometimes, the term "corporate bonds" is used to include all bonds except those issued by governments in their own currencies. Strictly speaking, however, it only applies to those issued by corporations. The bonds of local authorities and supranational organizations do not fit in either category.

Corporate bonds are often listed on major exchanges (bonds there are called "listed" bonds) and ECNs, and the coupon (i.e. interest payment) is usually taxable. Sometimes this coupon can be zero with a high redemption value. However, despite being listed on exchanges, the vast majority of trading volume in corporate bonds in most developed markets takes place in decentralized, dealer-based, over-the-counter markets.

Some corporate bonds have an embedded call option that allows the issuer to redeem the debt before its maturity date. Other bonds, known as convertible bonds, allow investors to convert the bond into equity.

Corporate Credit spreads may alternatively be earned in exchange for default risk through the mechanism of Credit Default Swaps which give an unfunded synthetic exposure to similar risks on the same 'Reference Entities'. However, owing to quite volatile CDS 'basis' the spreads on CDS and the credit spreads on corporate bonds can be significantly different.

Corporate debt fall into several broad categories:

secured debt vs unsecured debt

senior debt vs subordinated debt

Generally, the higher one's position in the company's capital structure, the stronger one's claims to the company's assets in the event of a default.

Risk analysis

Compared to government bonds, corporate bonds generally have a higher risk of default. This risk depends on the particular corporation issuing the bond, the current market conditions and governments to which the bond issuer is being compared and the rating of the company. Corporate bond holders are compensated for this risk by receiving a higher yield than government bonds. The difference in yield reflects the higher probability of default, the expected loss in the event of default, and may also reflect liquidity and risk premia.

Other risks in Corporate Bonds

-Default Risk has been discussed above but there are also other risks for which corporate bondholders expect to be compensated by credit spread. This is, for example why the Option Adjusted Spread on a Ginnie Mae MBS will usually be higher than zero to the Treasury curve.

-Credit Spread Risk. The risk that the credit spread of a bond (extra yield to compensate investors for taking default risk), which is inherent in the fixed coupon, becomes insufficient compensation for default risk that has later deteriorated. As the coupon is fixed the only way the credit spread can readjust to new circumstances is by the market price of the bond falling and the yield rising to such a level that an appropriate credit spread is offered.

-Interest Rate Risk. The level of Yields generally in a bond market, as expressed by Government Bond Yields, may change and thus bring about changes in the market value of Fixed-Coupon bonds so that their Yield to Maturity adjusts to newly appropriate levels.

-Liquidity Risk. There may not be a continuous secondary market for a bond, thus leaving an investor with difficulty in selling at, or even near to, a fair price. This particular risk could become more severe in developing market, where a large amount of junk bonds belong, such as China, Vietnam, Indonesia, etc.

-Supply Risk. Heavy issuance of new bonds similar to the one held may depress their prices.

-Inflation Risk. Inflation reduces the real value of future fixed cash flows. An anticipation of inflation, or higher inflation, may depress prices immediately.

-Tax Change Risk. Unanticipated changes in taxation may adversely impact the value of a bond to investors and consequently its immediate market value.

2. GOVERNMENT BONDS

A government bond is a bond issued by a national government, generally promising to pay a certain amount (the face value) on a certain date, as well as periodic interest payments. Bonds are debt investments whereby an investor loans a certain amount of money, for a certain amount of time, with a certain interest rate, to a company or country. Government bonds are usually denominated in the country's own currency. Bonds issued by national governments in foreign currencies are normally referred to as sovereign bonds, although the term "sovereign bond" may also refer to bonds issued in a country's own currency.

History

The first ever government bond was issued by the Bank of England in 1693 to raise money to fund a war against France. It was in the form of a tontine. Later, governments in Europe started issuing perpetual bonds (bonds with no maturity date) to fund wars and other government spending. The use of perpetual bonds ceased in the 20th century, and currently governments issue bonds of limited duration.

Risk

Credit risk

Government bonds are usually referred to as risk-free bonds, because the government can raise taxes or create additional currency in order to redeem the bond at maturity. Some counter examples do exist where a government has defaulted on its domestic currency debt,

such as Russia in 1998 (the "ruble crisis"), though this is very rare (see national bankruptcy). Another example is Greece in 2011. Its bonds were considered very risky, in part because Greece did not have its own currency.

Currency and inflation risk

As an example, in the US, Treasury securities are denominated in US dollars. In this instance, the term "risk-free" means free of credit risk. However, other risks still exist, such as currency risk for foreign investors (for example non-US investors of US Treasury securities would have received lower returns in 2004 because the value of the US dollar declined against most other currencies). Secondly, there is inflation risk, in that the principal repaid at maturity will have less purchasing power than anticipated if the inflation rate is higher than expected. Many governments issue inflation-indexed bonds, which protect investors against inflation risk by increasing the interest rate given to the investor as the inflation rate of the economy increases.

Terminology

In the UK, government bonds were called "government stock" or "treasury stock" and the older issues are still called "treasury stock". Newer issues are called "gilts". The name "bond" was reserved for fixed-value investments, which were not tradeable on the stock market. Inflation-indexed bonds are called Index-linked gilts in the UK.

Issuers

1. Supranational Agencies

A supranational agency, such as the World Bank, levies assessments or fees against its member governments. Ultimately, it is this support and the taxation power of the underlying national governments that allow these organizations to make payments on their debts.

2. National Governments

The "central" or national governments also have the power to print money to pay their debts, as they control the money supply and currency of their countries. This is why most investors consider the national governments of most modern industrial countries to be almost "risk-free" from a default point of view.

3. Provincial or State Governments

Provincial or state governments also issue debt, depending on their constitutional ability to do this. Canadian provinces, notably Ontario, borrow more than many smaller countries. Most investors consider provincial or state issuers to be very strong credits because they have the power to levy income and sales taxes to support their debt payments. Since they can not control monetary policy like national governments, they are considered lesser credits than national governments.

4. Municipal and Regional Governments

Cities, towns, counties and regional municipalities issue bonds supported by their property taxes. School boards also issue bonds, supported by their ability to levy a portion of property taxes for education.

5. Quasi-Government Issuers

Many government related institutions issue bonds, some supported by the revenues of the specific institution and some guaranteed by a government sponsor. In Canada, Federal government agencies and Crown corporations issue bonds. For example, The Federal Business Development Bank (FBDB) and the Canadian Mortgage and Housing Corporation (CMHC) bonds are directly guaranteed by the Federal government. Provincial crown corporations such as Ontario Hydro and Hydro Quebec are guaranteed by the Provinces of Ontario and Quebec respectively.

3. ASSET-BACKED SECURITIES

Asset-backed securities are bonds that are based on underlying pools of assets.

A special purpose trust or instrument is set up which takes title to the assets and the cash flows are "passed through" to the investors in the form of an asset-backed security.

The types of assets that can be "securitized" range from residential mortgages to credit card receivables.

All asset-backed securities are securities which are based on pools of underlying assets. These assets are usually illiquid and private in nature. A securitization occurs to make these assets available for investment to a much broader range of investors.

The "pooling" of assets occurs to make the securitization large enough to be economical and to diversify the qualities of the underlying assets.

Residential mortgages, for example, provide some insight into the development of the asset-backed securities market. Before the development of the mortgage-backed securities market in the early 1980s, each residential mortgage underwritten was a unique transaction. Joe Q. Public would walk into his bank or trust company and enter into a mortgage. By way of example, Joe chooses Lack Trust Company. Joe enters into a mortgage on a specific real estate property, 100 Easy Street in the Hills of Richmond, with the good people of Lack Trust. Sounds easy. But think of what has to happen for this mortgage to be underwritten. Lack Trust must check Joe's credit (salary, assets, etc.) and establish the worth of the property through an appraisal. Joe and Lack Trust then negotiate and establish the terms. This includes the amount and interest rate of the mortgage, the amortization of principal, as well as the prepayment terms. Lack Trust then has to hire a lawyer to register the mortgage against the property with a property registry office.

It can easily be seen that Joe's mortgage is an unique thing. There are no other mortgages on 100 Easy Street with Joe as the borrower on those terms and conditions. That is why most

mortgages were held by the financial company that originated them. Trading was awkward, as the mortgages had to each be evaluated and administered differently. The originating organization usually kept the servicing and were loath to part with their mortgages. Only very large institutional investors participated in this market. Smaller investors did not have the expertise to evaluate the mortgages, or a large enough portfolio to properly diversify. If a single mortgage was in the $200,000 range, a maximum 10% position would require a total portfolio of over $2,000,000 to be properly diversified. Therefore, for an individual investor, if their portfolio was to be properly diversified, a mortgage was an awkward asset to own.

If we combine Joe and five hundred other borrowers in a mortgage "pool" we have something that is bigger, which makes it more economical to issue, and better in credit quality, because of the diversification from the large number of mortgages. In a total pool of $100 million, no one mortgage of $200,000 is more 5% and not a large enough part of the pool to "skew" the pool's characteristics in any one aspect. If, for example, Easy Street turns out to be the site of a former radium factory, the fact Joe's house is worth less than we expected is not a fatal issue for the pool of assets as a whole.

Administration of the pool of mortgages is more systematic as well. We can have the same "servicing agent" collect all the monies from all the mortgages and "pass it through" to the investors via a central trustee. We can have the payments made to the investors at the same date each month. We can even supply aggregate data and statistics on the pool to investors, such as the "Weighted Average Coupon" (WAC), or "Remaining Amortization" (RAM).

One can now see that this unruly mass of mortgages is starting to look pretty much like a boring old bond to an investor. One payment from one source, once a month. Combined with a "book-based" custody system, we have now made a source of cash flows that "walks and talks like a bond". Not bad for something that used to be a lump of unique assets.

The wonder of securization is that it takes a wide variety of formerly illiquid and directly held assets and makes them available to many investors in the form of asset-backed securities. This

simple process can be applied to all sorts of cash flow producing assets. If a retailer needs cash, it securitizes part of its outstanding credit card balances from its customers into a "credit card receivables trust". An auto leasing firm takes the outstanding automobile lease balances and turns them into an "auto receivables trust". A bank takes a group of its higher quality customers and creates an "evergreen revolving financing trust" which constantly takes high quality receivables and finances them by issuing bonds from the trust.

4. EUROBONDS

A Eurobond is an international bond that is denominated in a currency not native to the country where it is issued. Also called external bond; "external bonds which, strictly, are neither Eurobonds nor foreign bonds would also include: foreign currency denominated domestic bonds. . ."[2] It can be categorised according to the currency in which it is issued. London is one of the centers of the Eurobond market, but Eurobonds may be traded throughout the world - for example in Singapore or Tokyo.

Eurobonds are named after the currency they are denominated in. For example, Euroyen and Eurodollar bonds are denominated in Japanese yen and American dollars respectively. A Eurobond is normally a bearer bond, payable to the bearer. It is also free of withholding tax. The bank will pay the holder of the coupon the interest payment due. Usually, no official records are kept. The word Eurobond was originally created by Julius Strauss.[citation needed]

The first European Eurobonds were issued in 1963 by Italian motorway network Autostrade.[3] The $15 million six year loan was arranged by London bankers S. G. Warburg.[4][5]

The majority of Eurobonds are now owned in 'electronic' rather than physical form. The bonds are held and traded within one of the clearing systems (Euroclear and Clearstream being the most common). Coupons are paid electronically via the clearing systems to the holder of the Eurobond (or their nominee account).

5. EXTENDIBLE/RETRACTABLE BONDS

Extendible and retractable bonds have more than one maturity date. An extendible bond gives its holder the right to extend the initial maturity to a longer maturity date. A retractable bond gives its holder the right to advance the return of principal to an earlier date than the original maturity. Investors use extendible/retractable bonds to modify the term of their portfolio to take advantage of movements in interest rates. The characteristics of these bonds are a combination of their underlying terms. When interest rates are rising, extendible/retractable bonds act like bonds with their shorter terms When interest rates fall, they act like bonds with their longer terms.

Extendible/retractable bonds are created by issuers because they pay a lower interest rate on these bonds than would otherwise be case or they "sweeten" the issue with this feature, making the issue easier to sell. Buyers are attracted to these bonds because the extension or retraction option is attractive to them.

Extendible Bonds

An extendible bond gives its holder the right to "extend" its initial maturity at a specific date or dates. The investor initially purchases a shorter term bond combined with the right to extend its term to a longer maturity date. An investor purchases an extendible bond to have the ability to take advantage of potentially falling interest rates without assuming the risk of a long term bond. As interest rates fall, the price of a shorter term bond rises less than the price of a longer term bond. This means the extendible bond begins to behave or "trade" as a longer term bond. On the other hand, if interest rates rose, the extendible bond would behave as a shorter term bond.

Retractable Bonds

With a retractable bond, an investor owns a longer term bond with the right to "retract" it at a specific date. Consider an investor that believes that interest rates will rise and bond prices will

fall, but is not willing or able to sell out of bonds completely. This investor can buy a longer term retractable bond which behaves initially as a similar term long term bond. As interest rates rise the bond falls in price. Once its price is low enough, it will begin to behave as a short term bond and its price fall will be much less than a normal long term bond. At worst, the investor can retract it at the retraction date and receive the par amount back to reinvest.

Pricing Extendible/Retractable Bonds

Usually, the extension or retraction feature means that the price of an extendible/retractable bond is higher and the interest rate lower than other similar term bonds. The motivation of the issuer is obvious, having to pay a lower interest rate than would otherwise be the case. The investor's motivation comes from the "defensive" feature of these bonds. The investor gains the potential upside of a longer term bond with the price risk of a shorter term bond. Looking at it another way, the investor can lock in a longer term interest rate with the option to shorten at his or her discretion.

Originally, these bonds were created as "sweeteners" as a way to sell bonds more easily. The market conditions were not conducive to issuing longer term bonds or the issuer wanted a lower interest rate than was available at that time. Adding the extension or retraction feature made it easier to sell the issue or cheaper for the issuer. At that time, the "rule of thumb" was that these bonds should be issued .2% less in yield than a normal bond of the same issuer.

More recently, with the development of options and swap markets, these bonds are priced using option pricing techniques. These view extendible and retractable bonds as a combination of a normal bond and a "call option" (extendible) or "put option" (retractable). "Option Adjusted Spread" (OAS) analysis uses statistical "decision trees" to assess the worth of these options given historical patterns of interest rate movements.

Are Extendible/Retractable Bonds Attractive?

As with anything, you get what you pay for with extendible/retractable bonds. If an investor constantly invested in these bonds, the net result would be a lower return due to the lower yield of these bonds compared to normal bonds of the same term. An investor unable to accept the price risk of longer term bonds would be better off in extendible/retractable bonds than with exclusively shorter term bonds, as this would generate a higher yield and reduce the income risk of the portfolio. Investors with an interest rate view but not willing to accept the risk of being "out of the market" should use these bonds to protect their portfolios.

6. FOREIGN CURRENCY BONDS

A "foreign currency" bond is a bond that is issued by an issuer in a currency other than its national currency. Issuers make bond issues in foreign currencies to make them more attractive to buyers and to take advantage of international interest rate differentials. Foreign currency bonds can "swapped" or converted in the swap market into the home currency of the issuer. Bonds issued by foreign issuers in the United States market in U.S. dollars are known as "Yankee" bonds. Bonds issued in British pounds in the British bond market are known as "Bulldogs". Yen denominated bonds by foreign issuers are known as "Samurai" bonds.

The development of the world bond markets allowed bond issuers to bring issues in other than their home markets. For example, since the 1970s, the Canadian provinces have used the U.S. bond market as a major source of funding. The Canadian province of Ontario is one of the world's largest and most sophisticated non-sovereign borrowers. It brings bond issues in many different currencies and markets, seeking to fund at the lowest possible absolute rate. In the U.S. bond market, Ontario and Ontario Hydro, its power corporation, have many "Yankee" issues and is considered an alternative to domestic U.S. corporate issuers.

The "euromarket" is another major source of foreign currency bond issues. European investors will buy the bonds of well known issuers like Ford, Toyota or General Electric or their international subsidiaries, in many different currencies depending on their currency views. This makes for a constant arbitrage between the foreign and domestic bond markets as investors seek to gain the best possible yield employing currency hedges and swaps. A Canadian institutional investor does not really care if the original Ford Motor Credit Canada bond was issued in U.S. funds if he has swapped both the interest and principal payments into Canadian dollars. The large international swap banks like Citibank make markets buying and selling these swaps, which gives investors tremendous liquidity in these transactions. Dutch and Danish banks often issue in Canadian dollars in the European markets despite eventually requiring funding in their own currencies. They do this to take advantage of demands for Canadian currency issues and to lower their funding costs.

Foreign currency bonds have a vocabulary all their own. Bonds issued in foreign currencies are given the names listed beside the currencies below:

"Yankee Bonds" for U.S. dollars;

"Samurai Bonds" for Japanese Yen;

"Bulldog Bonds" for British pounds; and

"Kiwi Bonds" for New Zealand dollars.

A more recent innovation are bonds that are hybrids in currency terms, with their coupon and principal payments in different currencies. For example, some recent bonds have had their coupon payments in Yen with their principal amounts in Canadian dollars. This satisfies the needs of Japanese institutional investors for yen income while keeping the eventual return of principal in the national currency of the issuer.

Foreign currency bonds have a much different risk and return profile than domestic bonds. Not only is their price affected by movements in a foreign country's interest rate, they also change in value depending on the foreign exchange rates. In Canada, for example, the Canadian dollar has moved upwards to 4% in U.S. dollar terms in very short periods of time. This exchange rate movement would result in price changes of 4% in Canadian dollars which completely overwhelms the coupon income of a bond. Studies have shown that the longer term risk and return characteristics of foreign bonds in domestic currencies are closer to domestic equity returns than domestic fixed income returns.

7. CONVERTIBLE BONDS

A convertible bond is a bond that gives the holder the right to "convert" or exchange the par amount of the bond for common shares of the issuer at some fixed ratio during a particular period. As bonds, they have some characteristics of fixed income securities. Their conversion feature also gives them features of equity securities.

Convertible bonds are bonds. They have a coupon payment and are legally debt securities, which rank prior to all equity securities in a default situation. Their value, like all bonds, depends on the level of prevailing interest rates and the credit quality of the issuer.

The exchange feature of a convertible bond gives the right for the holder to convert the par amount of the bond for common shares a specified price or "conversion ratio". For example, a conversion ratio might give the holder the right to convert $100 par amount of the convertible bonds of Ensolvint Corporation into its common shares at $25 per share. This conversion ratio would be said to be " 4:1" or "four to one".

The share price affects the value of a convertible substantially. Taking our example, if the shares of the Ensolvint were trading at $10, and the convertible was at a market price of $100, there would be no economic reason for an investor to convert the convertible bonds. For $100 par amount of the bond the investor would only get 4 shares of Ensolvint with a market value of $40. You might ask why the convertible was trading at $100 in this case. The answer would be that the yield of the bond justified this price. If the normal bonds of Ensolvint were trading at 10% yields and the yield of the convertible was 10%, bond investors would buy the bond and keep it at $100. A convertible bond with an "exercise price" far higher than the market price of the stock is called a "busted convertible" and generally trades at its bond value, although the yield is usually a little higher due to its lower or "subordinate" credit status.

Think of the opposite. When the share price attached to the bond is sufficiently high or "in the money", the convertible begins to trade more like an equity. If the exercise price is much lower than the market price of the common shares, the holder of the convertible can convert into the stock attractively. If the exercise price is $25 and the stock is trading at $50, the holder can get 4 shares for $100 par amount that have a market value of $200. This would force the price of the convertible above the bond value and its market price should be above $200 since it would have a higher yield than the common shares.

Issuers sell convertible bonds to provide a higher current yield to investors and equity capital upon conversion. Investors buy convertible bonds to gain a higher current yield and less downside, since the convertible should trade to it bond value in the case of a steep drop in the common share price.

Investors traditionally use "breakeven" analysis to compare the coupon payment of the convertible to the dividend yield of the common shares. Modern techniques of option analysis examine the convertible as a bond with an equity option attached and value it in this manner.

8. HIGH YIELD OR "JUNK" BONDS

A high yield, or "junk", bond is a bond issued by a company that is considered to be a higher credit risk. The credit rating of a high yield bond is considered "speculative" grade or below "investment grade". This means that the chance of default with high yield bonds is higher than for other bonds. Their higher credit risk means that "junk" bond yields are higher than bonds of better credit quality. Studies have demonstrated that portfolios of high yield bonds have higher returns than other bond portfolios, suggesting that the higher yields more than compensate for their additional default risk.

High yield or "junk" bonds get their name from their characteristics. As credit ratings were developed for bonds, the credit rating agencies created a grading system to reflect the relative credit quality of bond issuers. The highest quality bonds are "AAA" and the credit scale descends to "C", and finally to the "D" or default category. Bonds considered to have an

acceptable risk of default are "investment grade" and encompass "BBB" bonds and higher. Bonds "BB" and lower are called "speculative grade" and have a higher risk of default.

Rule makers soon began to use this demarcation to establish investment policies for financial institutions, and government regulation has adopted these standards. Since most investors were restricted to investment grade bonds, speculative grade bonds soon developed negative connotations and were not widely held in investment portfolios. Mainstream investors and investment dealers did not deal in these bonds. They soon became known as "junk" since few people would accept the risk of owning them.

Before the 1980s, most junk bonds resulted from a decline in credit quality of former investment grade issuers. This was a result of a major change in business conditions, or the assumption of too much financial risk by the issuer. These issues were known as "fallen angels".

The advent of modern portfolio theory meant that financial researchers soon began to observe that the "risk-adjusted" returns for portfolios of junk bonds were quite high. This meant that the credit risk of these bonds was more than compensated for by their higher yields, suggesting that the actual credit losses were exceeded by the higher interest payments

Underwriters being creative and profit-oriented, soon began to issue new bonds for issuers that were less than investment grade. This led to the Drexel-Burnham saga, where Michael Millken led a major investment charge into junk bonds in the late 1980s, which ended with a scandal and the collapse of many lower rated issuers. Despite this, the variety and number of high yield issues recovered in the 1990s and is currently thriving. Many mutual funds have been established that invest exclusively in high yield bonds, which have continued to have high risk-adjusted returns.

High yield bond investment relies on credit analysis. Credit analysis is very similar to equity analysis in that it concentrates on issuer fundamentals, and a "bottom-up" process. It is concentrated on the "downside" risk of default and the individual characteristics of issuers. Portfolios of high yield bonds are diversified by industry group, and issue type. Due to the high minimum size of bond trades and the specialist credit knowledge required, most individual investors are best advised to invest through high yield mutual funds.

9. INFLATION-LINKED BONDS

An inflation-linked bond is a bond that provides protection against inflation. Most inflation-linked bonds, the Canadian "Real Return Bond "(RRB), the British "Inflation-linked Gilt" (ILG) and the new U.S. Treasury "inflation-protected security" (IPS) are principal indexed. This means their principal is increased by the change in inflation over a period. In most countries, the Consumer Price Index (CPI) or its equivalent is used as an inflation proxy. As the principal amount increases with inflation, the interest rate is applied to this increased amount. This causes the interest payment to increase over time. At maturity, the principal is repaid at the inflated amount. In this fashion, an investor has complete inflation protection, as long as the investor's inflation rate equals the CPI.

We must compare an inflation-linked bond to a conventional or "nominal" bond to understand it properly. A normal bond pays its coupon on a fixed principal amount. Using the Government of Canada 8% bond maturing in 2023 as an example, we are due 8%, or $8 on every $100 of principal, each year until we are finally repaid our principal of $100 at maturity. Contrast this with the Canadian RRB, the 4.25% maturing in 2021. It pays a 4.25% "real" interest rate or

$4.25 on its principal each year. But the principal increases with inflation, which is based on the Canadian CPI. For example, when Canadian inflation, the CPI, was 1.8% in 1995, the principal amount was increased by 1.8%. Since its issue in November 1991, the RRB has seen its principal amount increase by 8% to $108. The 4.25% coupon now generates a payment of $4.60 versus its original payment of $4.25. At maturity, when the principal will be repaid by the Canadian government, the principal amount will have increased to well over $200.

By applying a "real" interest rate or coupon to the principal amount, an inflation-linked bond protects the investor from unexpected changes in the consumer price index. Normally, bond investors demand an extra "yield premium" or compensation for inflation risk. Since inflation-linked bonds are not exposed to inflation, their yield is lower than normal or nominal bonds. As of December 1996, a thirty year Canada bond has a yield of about 7%. The Canadian RRB has a yield of 4.2%. The 2.8% difference between these two bonds reflects the "break-even inflation rate". This means that inflation would have to average more than 2.8% per year until the maturity of the bond for the inflation-linked bond to do better than another bond of similar term. Investors do not necessarily expect inflation to be as high as 2.8%, since they do not know what the future will bring they are willing to sacrifice some current yield for inflation protection on the principal.

10. U.S. TREASURY INFLATION PROTECTED SECURITIES (TIPS)

A new age dawned in the U.S. capital markets on Wednesday, January 29, 1997. The United States Treasury made its first issue of an inflation-linked bond, the 3.375% of 2007. This bond increases its principal by the changes in the Consumer Price Index (CPI). Its interest payment is calculated on the inflated principal, which is eventually repaid at maturity. This gives an investor the ability to protect against inflation while providing a certain "real" return over an investment horizon. Despite critics and uncertainty over the "great inflation debate", the auction went extremely well with interest five times the size of the $7.0 billion issue. The "real yield" of the TIP reached more than 3.5% in the "when issue" trading before the auction but fell dramatically to 3.3% in the aftermarket trading.

It's the "Real" Thing

The issue of the TIP is a major development in the U.S. capital markets. For the first time, investors will be able to achieve a certain "real return" above inflation over their investment period. A normal or "nominal" bond pays its interest on a fixed principal amount, which is repaid at maturity. Inflation is a major risk to a nominal bond holder, since increasing inflation means reduced "purchasing power" is in the face of increasing prices.

A good example of a TIPS investor would be an individual setting aside retirement funds in an IRA. Purchasing a $100,000 TIPS would lock in this amount in real terms. Whatever the inflation rate until the eventual retirement, the $100,000 would be completely "indexed" or have its value increased to offset any increases in inflation.

The Naked Bond?

The TIPS issue used the structure of the Canadian inflation-linked program, which allows for "stripping" or the creation of "zero coupon" bonds. This separates the coupon payments or "coupons" from the principal amount or "residual". While this has been done for years with nominal bonds, it promises a new capability for investors. Using the "real zeroes", an investor could place an amount in a specific term and ensure an inflation proof" result. For example, an insurance company wishing to set funds aside to pay claims which are linked to inflation could purchase the exact amount of "real zeroes" to cover the claim in today's dollars. No matter what the intervening inflation, the amount invested would grow to exactly equal the amount required to settle the claim.

How Good is a "Real" Thing

The value of the inflation protection of the TIPS is being hotly debated in investment circles. To simplify the arguments, we can compare the yield available on a normal or "nominal" 10 year Treasury Bond to the TIP. At current yields, a nominal 10 year Treasury yields 6.4%. If we subtract inflation, currently 3.3% for the CPI, we get a "real yield" of 3.1% (6.4 - 3.3 = 3.1). The current yield of the TIPS is 3.3% "real". This means that the real yield of the TIPS is .2% higher than the same term nominal Treasury. We can think of it another way. Add 3.3% inflation to the TIPS yield of 3.3% and we have a total yield of 6.6% which exceeds the nominal treasury yield of 6.4%. Given that the TIPS is inflation-risk free, this doesn't make a lot of sense. We receive more interest for a an inflation-protected bond than a normal risk bond!

The reasons for this are threefold:

First, with any new investment, especially in the conservative bond market, the first issues come "cheap", or inexpensive relative to standard "plain vanilla" issues, which attracts investors and compensates for the new nature of the security.

The second reason is the smaller size of the TIPS market which makes it "illiquid" or harder to trade than the huge existing Treasury market. Given the $7.0 billion size of the initial TIPS issue, this might come as a surprise, but this is small change compared to the hundreds of billions of existing Treasury bonds.

The third and perhaps the most important reason is the uncertainty over the status of the current CPI index. Many politicians, government officials and even Alan Greenspan, the Federal Reserve Chairman, are of the belief that the current CPI, as calculated by the Bureau of Labour Statistics (BLS), is overstated.

The Great Inflation Debate

Conveniently, a lowering of the CPI would help to balance the budget and this is the political incentive. The widespread and vocal discussion has created much uncertainty in the marketplace about TIPS, since its principal is increased by the published CPI. The thesis that the CPI is overstated by .5% to 1.5% has led to a much higher yield on the TIPS than would probably otherwise be the case. Not a smart move by the government and those involved, but whoever said that politicians were smart? The arguments for and against the CPI's accuracy are being mustered but in any event, the eventual resolution will be well into the future. So far we've only heard one side of the story and the other will soon come out. Any restatement will take time and research. This could provide some shorter term value to prescient investors.

Other Countries Have Been Doing It

The United Kingdom has issued "Inflation-linked Gilts" (ILGs) since 1981 and has a variety of different terms of issues. Canada issued the 4.25% of 2021 "Real Return Bond" (RRBs) in 1991 and has reopened this issue many times since. Canada added a second issue, the 4.25% of 2026 last year. Sweden, Australia and New Zealand also issue inflation-linked bonds.

The Time to Buy Insurance is When You Don't Need It!

As the old saying goes: "the time to buy insurance is when you don't need it". This holds true for the TIPS as well. Inflation, remarkably under control for the past five years at 3% plus or minus a bit, is the biggest anger a fixed income investor faces. The fact that most bond managers, and investors, can't conceive of generally higher inflation means that it is not factored into the price of current bonds. Compared to the savaged bond investors of the 1970s, who called bonds "certificates of confiscation", the current crop of bond managers is diving into 100 year securities and fretting about upcoming bond shortages. Almost twenty years of declining interest rates and inflation has made wary bond managers an extinct species.

The "trend is your friend", low-inflation, camp has made the inflation protection of the TIPS very cheap. It wasn't so long ago that Saddam Hussein's army was in Kuwait and oil prices were going through the roof. Don't wait until inflation springs, do it now!

11. MORTGAGE-BACKED SECURITIES

A mortgage-backed security (MBS) is a security that is based on a pool of underlying mortgages. MBS are usually based on mortgages that are guaranteed by a government agency for payment of principal and a guarantee of timely payment. The analysis of MBS concentrates on the nature of the underlying payment stream, particularly the prepayments of principal prior to maturity.

Before the development of the mortgage-backed securities market in the early 1980s, each residential mortgage underwritten was a unique transaction. Joe Q. Public would walk into his bank or trust company and enter into a mortgage. Say Joe chooses Lack Trust Company. Joe enters into a mortgage on a specific real estate property, 100 Easy Street in the Hills of Richmond, with the good people of Lack Trust. Sounds easy. But think of what has to happen for this mortgage to be underwritten. Lack Trust must check Joe's credit (salary, assets etc.) and establish the worth of the property through an appraisal. Joe and Lack Trust then negotiate and establish the terms. This includes the amount and interest rate of the mortgage, the amortization of principal as well prepayment terms. Lack Trust then has to hire a lawyer to register the mortgage against the property with a property registry office.

It can easily be seen that Joe's mortgage is an unique thing. There are no other mortgages on 100 Easy Street with Joe as the borrower on those terms and conditions. That is why most mortgages were held by the financial company that originated them. Trading was awkward, as the mortgages had to each be evaluated and administered differently. The originating organization usually kept the servicing and were loath to part with their mortgages. Only very large institutional investors participated in the market. Smaller investors didn't have the expertise to evaluate the mortgages or a large enough portfolio to properly diversify. If a single mortgage was in the $200,000 range, a maximum 10% position would require a total portfolio of over $2,000,000 to be properly diversified. Therefore, for an individual investor, if their portfolio was to be properly diversified, a mortgage was an awkward asset to own.

By grouping a large number of mortgages together in a "pool", the uniqueness of each mortgage is submerged in the whole. Let's take 500 mortgages at $200,000. This gives us a pool of $100 million of mortgages. We can take the aggregated statistics such the "weighted average maturity" (WAM) or the "remaining amortization" (RAM) and use these to describe the pool. We can then make sure no mortgage is too large a portion of the pool. Arrangements are made such that the "servicing agent" collects the mortgage payments and gives them to "central paying agent" which, in turn, "passes through" the payments to the final investor. We now have something that looks very much like a bond. However, we do have a problem: how do we assess each of the mortgages for their creditworthiness?

Enter mortgage insurance. Mortgage insurance guarantees the principal of a mortgage against default by the borrower. This process provides investors with a "commoditized" credit risk. The large mortgage insurers in the United States and Canada are government or quasi-government agencies. These agencies use the credit standing of their respective national governments to guarantee mortgage loans. In Canada, the Central Housing and Mortgage Corporation (CHMC) guarantees mortgages for different programs backed by its borrowing power under federal government legislation, the National Housing Act (NHA). Investors could then view the credit risk on the principal amount as equivalent to the credit risk of Canadian government bond.

Investors were still wary of the "timely payment" issue, since the process of collecting on a defaulted loan was a lengthy affair. In the 1980s, some investors in NHA mortgages in Canada were unable to collect on their defaulted mortgages from the CHMC for several years. This meant they lost the use of their money and the interest it could earn for a lengthy period, although they eventually collected their principal and accrued interest. The Canadian MBS program remedied this by adding a "guarantee of timely payment" in 1987. This guarantee of principal and timely payment meant that the credit risk was removed from the equation. With a defaulted mortgage, the payments would be kept up until the principal amount was repaid by the guarantor, CMHC.

The removal of credit risk does not mean that MBS are without risk. There is a major risk inherent in the cash flows called "prepayment risk". Let's say that Joe was unusually frugal and decided to pay off his mortgage early. All his neighbours, who also were in the same pool (we did not obviously diversify geographically) decide to follow suit. We, the investors, are sitting pretty. We know we're safe credit wise for the next five years. But when Joe and his neighbours walk in the door of Lack Trust, our portfolio starts to shudder. Their combined frugality means that we get our principal back early. Not bad, but to the investors it also depends on what interest rates have done since the pool was issued.

Let's say we bought the pool when interest rates were high in early 1994. We have a pool with a coupon of almost 9%. Two years later, we have interest rates for the remaining three year term at somewhere around 5%. Oh, oh. We thought we would get 9% for five years, yet two years into the term we are forced to reinvest at 5%. That means we lose 4% for three years. OUCH! Even if there are a few stalwarts who decide not to pay their mortgage off, nobody is going to want to buy something at $112 that could be paid off at any time. Therefore, the price falls to the point where the market thinks its being compensated for the prepayment risk (which is going to be not too far above par). Whether we are paid out early or not, we are going to take a bath on this one. We would have done much better to put our money in a normal bond that did not prepay.

Now consider whether or not we should buy the pool in the current low interest rate environment. By religiously reading the bond articles on our favourite internet site we have learned about reinvestment risk, prepayment risk and the effect of interest rate changes on bond values. We have stayed fully invested in long-term bonds until now (December 1996) but have now decided to become defensive as we think rates will rise. Now assume, going forward a year, we are right (this only happens on the Internet). The economy surges. Inflation and interest rates surge. Central bankers fling themselves into Jacuzzis in fits of despair. How have our MBS done considering Joe and his neighbors have decided to pay off their mortgages after two years (their houses have doubled in price and they're trading up)?

Think of it. Dream of it. Interest rates are back to 9%. Our pool carries an average mortgage rate of 5% and coupon nearly the same. When Joe and his frugality bunch pay us out, we sign up for Club Med, despite the impending recession of 1998. We get $100 of principal invested at 5% returned to us to invest at 9%. Even if some of the pool doesn't prepay, the rise in interest rates has knocked the value of the MBS down as interest rates have risen. Our $100 invested is now worth less than $90. Except that everyone recognizes that any prepayments will be at $100 and all pools tend to prepay something. People move, default and even are frugal and prepay their mortgage even though it does not make economic sense. The MBS will do much better than a normal bond that doesn't prepay.

IT'S THE PREPAYMENT RISK, STUPID, to badly paraphrase an American Presidential candidate. You won't hear much about prepayments from your favourite salesperson, but its the only thing that counts with MBS. A good trick is to watch out for the words "after analysis". This means that a certain prepayment experience has been assumed in calculating the yield. A smart analyst takes this with a "chunk of rock salt" and concentrates on the pool characteristics and prepayment experience of similar pools and issuers. She then tries out a few scenarios to see how things will go with varying interest rates and prepayment conditions. The trick is establishing the future payment stream and pricing it.

If you think interest rates are going to fall, avoid prepayable MBS. If you think they are going to rise, MBS might not be a bad investment. If you don't think you have an insight into interest rates, don't buy prepayable or "open" MBS. Try closed MBS or normal bonds. And remember your mantra: "it's the prepayment risk, stupid".

12. ZERO COUPON OR "STRIP" BONDS

Zero coupon or strip bonds are fixed income securities that are created from the cash flows that make up a normal bond.

The cash flows of a normal bond consist of the regular interest or "coupon" payments, that take place over the term of the bond, and the principal repayment that occurs at maturity of the bond. For example, the cash flows of the Government of Canada 8% bond with a maturity date of June 1, 2023 are:

$4 every December and June 1st up to and including June 1, 2023, representing 4% of the $100 par value; and

$100 on June 1, 2023, representing the repayment of the principal or par amount of the bond.

Taken individually, each of these payments is an obligation of the issuer, in this case, the Government of Canada. The process of "stripping" a bond involves deppositing bonds with a trustee and having the trustee separate the bond into its individual payment components. This allows the components to be registered and traded as individual securities. The interest payments are known as "coupons" after their source of cash flow, and the final payment at maturity is known as the "residual" since it is what is left over after the coupons are stripped off. Both coupons and residuals are known as "zero coupon" bonds or "zeros".

Initially, when this process first took place in the early 1980s, the individual coupons were "physical", which meant that an actual paper certificate existed for each coupon and the residual. Now these securities are "book based" which means that they are entries on a centralized financial registry system known as the Central Depository System (CDS).

Once a bond has been stripped, a trustee directs the appropriate amount of the interest or maturity payment to the security holders. The holder of a zero coupon receives the par amount of the particular term of the zero that she holds. For example, an investor holding $100,000 par amount of the December 1, 2001 coupon would receive $100,000 on that date.

Conceptually, a zero coupon security is just like a Treasury Bill or "T-Bill". The investor pays something up front in exchange for a promise to receive $100 on the maturity date. Take our example of the coupons and residual generated by stripping the Canada 8% of 2023. If we start

on December 1, 1996 the first two payments are identical to a 6 month and 1 year T-Bill. An investor would receive $100 on June 1st and December 1st for each $100 par amount she purchased of these terms of coupons.

The basic mathematics are easy. What should an investor pay for the 1 year coupon? If the investor demands a 4% return over a one year period, she should pay something around $96 for the $100 maturity value (actually $96.154 since we're starting at less than $100).

The longer coupons get a bit more complicated. Take the coupon due on December 1, 2001, five years from December 1, 1996. What do we pay for this $100? First of all, we need to consider what interest rate would be appropriate. Reflecting on the term structure of interest rates, we know that we should use the yield on a similar term Government of Canada bond. Being bond market fans, we just happen to know that there is a Government of Canada issue the 9.75% of December 1, 2001. We also know that it currently yields 5.6% semiannually.

As a rough cut, forgetting the compounding of interest (interest-on-interest) and the conversion to semiannual yields, we know that 5.6% for 5 years is 28%. This means if we pay something around $72 (100-28) on December 1, 1996 for the $100 coupon due on December 1, 2001, we will earn something around 30% over the period or 6% a year.

Pulling out our trusty bond calculator, we can actually do the calculation. At a semiannual yield of 5.6%, the price works out to be $75.91. At a semiannual yield of 6%, the price works out to be $74.44.

Of course, nothing is as easy as it seems. The yield of a zero coupon bond is different than the yield of a normal bond of the same issuer. This difference of "spread" reflects the economics or profits available to investment dealers from "stripping" activities and the supply and demand for zero coupon bonds. There is also a difference in yield between coupons and

residuals which reflects the larger size of residuals and the economies of trading compared to many smaller coupon positions or "lines".